Shifting From Economies of Scale to Network Externalities

by Tanya Bodell, FTI Consulting

The structure of the power industry was founded on the premise that the production and delivery of electricity is a natural monopoly and therefore best served by a regulated franchise. Changes in commodity prices, new generation technologies, and emergence of independent power producers in the 1980s challenged this premise, resulting in industry restructuring.

Although competitive markets developed for generation and retail, transmission and distribution delivery networks continued to be considered natural monopolies. During the past decade, however, the emergence of independent transmission companies questioned this assumption. The Federal Energy Regulatory Commission’s (FERC’s) recent notice of pending regulation (NOPR) on transmission planning and cost allocation (RM23-10-0), combined with its request for comments regarding regulatory treatment of energy storage (AD10-13-000), indicate that delivery networks—the last bastion in power upholding the theory of natural monopoly—are under siege. The challenger: network externalities.

Network Externalities

Natural monopolies are characterized by lower average costs as production increases. Network externalities generate changes in value as participation increases. A positive network externality occurs when the value of a product or service increases as more people use it; a negative externality results from resource constraints on the system resulting from increased participation.

The power industry is replete with networks. The transmission and distribution systems are traditional networks while newer networks include smart grid and electric vehicle interconnections with the physical grid. As with telephones, fax machines, the Internet and social websites, one party’s participation in these networks impacts the value to other participants. And just like other networks, proper cost allocation is critical if network benefits are to be realized.

Lessons Learned From Other Networks

FERC’s recent NOPR and request for comments ask the critical question: How do we need to structure participation in electricity networks to maximize the net value to society in the face of new entrants, emerging technologies and changing business models? In addressing this question, lessons learned from establishing other networks are relevant:

  • Distinguish between network externalities and network effects. A network externality is a situation that creates network effects. Most network effects can be resolved using ownership and contracts to internalize these effects without addressing the network externality itself.
  • Minimize barriers to entry. Network effects are optimized with greater participation subject to resource constraints. Eliminate barriers to participation and encourage new entry.
  • Standardize to create larger markets. Standards allow more participants to interact in greater ways, generating value for the entire system. Minimize unnecessary market segmentation.
  • Enable return on investment. Investment will not occur unless investors have the opportunity to recover an appropriate return on their capital. Create structures that encourage investment and allow such investment to earn appropriate levels of return.
  • Regulate judiciously. Distinguish between investments that benefit the entire system vs. investments that benefit individual participants. Regulate the former only to the extent it would not happen in a competitive market, and make the latter competitive to encourage optimal investment.
  • Allocate costs accordingly. In general, beneficiaries should pay. This should be tempered, however, with the willingness of beneficiaries to pay (in economic parlance, elasticity of demand) and variability around the value likely to accrue to beneficiaries. The goal of government intervention should be to maximize the collective surplus to consumers and suppliers and allocate the surplus using market-based solutions.
  • Avoid a tragedy of the commons. If individual incentives result in an outcome that is not in the best interests of society, government intervention might be required. Determine the payout structure under current incentives and modify where required to maximize the collective net benefit to the network.

Although some of these rules might conflict in practice, remember these objectives when addressing how to maximize the value of a network. Actual and potential network participants must be involved in the discussion. If you are a new entrant, value the benefits you bring to the entire system. Suggest markets or arrangements that incorporate the value of those benefits into prices you will receive and costs you will pay.

Failure to recognize the shortcomings of existing markets to properly price your impact on the system might result in a tragedy of the commons where the value you can provide remains unrealized.

Author

Tanya Bodell is a managing director at FTI Consulting and co-founder of the Electricity Consulting Group. Reach her at tanya.bodell@fticonsulting.com.

“A world governed by networks is rewriting the rules for how you build companies, market products and create value.”
Eric Ransdell, August 1999 issue of Fast Company, referring to Web companies

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